[MUSIC] There are three important questions we have to ask to fully evaluate the warring schools of macroeconomics. Number one, what causes instability in the economy so that it deviates from its full employment output? Two, is the economy self correcting, and if so, what is the speed of the adjustment back to full employment output? And three, should the government adhere to a set of hard and fast rules, or rather use discretion in setting fiscal and monetary policy? So let's start with the first question. What can drive an economy away from its full employment output? The main stream view is Keynesian based. It holds that instability in the economy arises from two sources. The first, most common problem is significant changes in investment spending. And to a lesser extent consumption spending, both of which change aggregate demand. The second more occasional problem is adverse supply side shocks which change aggregate supply. Now in contrast to the Keynesian view, the Monetarists hold that it is inappropriate government policies that are the major cause of macroeconomic instability. In fact, modern monetarism is a classically based perspective. This is because, like classical economics, monetarism argues that the price and wage flexibility provided by competitive markets cause fluctuations in aggregate demand to alter product and resource prices, rather than output and employment. The problem, as Monetarists see it, is that wages can't adjust freely downward because of government policies, ranging from minimum wage and pro-union legislation, to guaranteeing prices for farm products, pro-business monopoly protections, and so on. Even more importantly, the Monetarists also blame the government's clumsy and often misguided attempts to achieve greater stability to activists monetary policies. This problem of a misguided government is rooted in the Monetarists view of the economy through the lens of the Equation of Exchange and quantity theory of money, which we examined in lecture four. You may recall from that lecture that if the velocity of money v is stable, and real output q is independent of the price level, changes in the money supply m can only lead to changes in inflation. Of course it is a matter of some debate as to whether the velocity of money is stable. And in fact Keynesians take the view that velocity is actually unstable. From the perspective of supply side economics, supply siders agree with the Keynesians that macroeconomic instability can result from supply side shocks. However, in this regard supply siders at least partly share the classical and monetarist view that it is often the government, not just droughts and oil price hikes, that is to blame for causing the shocks. Of particular concern to the supply siders are high tax rates and regulations that reduce supply incentives. Let's turn now to our second area of controversy, the question of whether the economy self corrects. In this debate, it not just a question of whether an economy corrects itself when instability does occur, economists also disagree as to the length of time it will take for any such self correction to happen. In this regard, both the monetarists and the new classical economists take the view that when the economy occasionally diverges from its full employment output, internal mechanisms within the economy automatically move it back to that output. This perspective is associated with the theories of adaptive and rational expectations that we have already discussed. This figure relates the new classical view of self correction. Here, an unanticipated increase in aggregate demand from AD1 to AD2 moves the economy from point A to point B. This causes the price level to rise from P1 to P2, as real output increases from Q1 to Q2. Now, in a new classical world, what do you think happens next to bring the economy back to Q1? And what do you think will happen to the price level. In the long run, nominal wages will rise to restore the real wages that have been eroded by inflation. This causes per unit production cost to rise, and eventually the short run aggregate supply curve shifts leftward and inward, from AS1 to AS2. As the economy moves from point b to point c, the price level rises from P2 to P3, and the economy returns to the full employment level of Q1. Now what about the speed of adjustment issue? Well here there is much controversy, even within the various schools of macroeconomics. For example, classically orientated monetarists usually hold the adaptive expectations view that people form their expectations on present realities, and only gradually change their expectations as experience unfolds. This implies that the shifts in the short run aggregate supply curves that we have just illustrated, may not occur for two or three years or even longer. On the other hand, the new classical economists accept the rational expectations assumption that workers anticipate some future outcomes before they even occur. This suggests that when price level changes are fully anticipated, the adjustments in our figures occur very quickly, indeed even instantaneously. So what do the Keynesians think about all this? Well, almost all economists today acknowledge that new classical economics has taught us some important lessons about the theory of aggregate supply. None the less, most mainstream economists strongly disagree with new classical rational expectations theory on the question of downward price and wage flexibility. In this regard, while the stock market, foreign exchange market and certain commodity markets experience day to day or even minute to minute price changes, including price declines. This is not true in many product markets, and in most labor markets. Indeed, there appears to be ample evidence, say mainstream economists, that many prices and wages are inflexible downward for long periods. As a result, it may take years for an economy to move from recession back to full employment output, unless it gets help from fiscal and monetary policy.
